How will falling oil prices translate into cheaper air fares?

Airline ticket prices to fall?As the price of Brent Crude falls to a six year low of $50 a barrel and aviation fuel costs plummet, there could be no better time to book a flight. How much though is the average passenger likely to save?

With the United States producing more “home grown” energy from shale gas and shale oil, the price of oil has fallen dramatically. Indications are that prices may stay low for some time to come as OPEC, the association of oil producers, has said that it will not restrict supply to bring prices back up.

These lower oil prices are now filtering through to the petrol pumps and so will the same happen in the airline industry?

It will come as no surprise that airlines are heavily affected by the price of aviation fuel. Airlines do hedge against sharp fuel price changes with forward contracts and so prices won’t change overnight. However airlines don’t hedge much beyond the short term because hedging always carries a cost, and the further forward you hedge the higher the cost. You are effectively paying a price to buy certainty.

So as these short term hedging contracts unwind and the price of new hedging contracts fall, airlines are going to enjoy lower fuel costs ….. and the savings could be significant.

We have examined the accounts of a typical airline (British Airways in this case) and translated their overheads to breakdown the cost of a £500 air fare.

 

Airline ticket breakdownAirline ticket breakdown graph

 

 

 

 

 

 

 

*Analysis based on British Airways financial statements 2014

As you can see, fuel is the number one cost that the airline faces, making up about 30% of the price of a ticket. With the price of oil falling 65% from $110 a barrel in less than 12 months, you could be forgiven for thinking that a 65% drop in the oil price could translate to a 65% drop in aviation fuel cost.

However the picture is not quite that simple. Obviously the cost of the raw material (crude oil in this case) only makes up a proportion of the final cost of aviation fuel. There are refinery and distribution costs (around $5-$10 a barrel) and they obviously don’t change whatever the price of the barrel. Aviation fuel duty is also fixed (around £0.40 a litre) and so this also will apply a dampener on the price of aviation fuel falling.

Another dampener would be the airline taking a profit element from the drop and also hedging to a price that is higher than market price. It is only when then market price stays low for a consistent period of time will long term hedge prices fall to close the market price.

But even with these dampeners we could see as much as a 30% drop in aviation fuel costs being carried into lower airline tickets. On a typical £500 airline ticket this this would equate to a £45 saving ie 9%.

This is obviously a welcome saving and when combined with the reductions in Air Passenger Duty for long haul flights and its abolition for children under 12, there could be no better time to book that long overdue holiday!

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